Assets are facing significant headwinds from inflation and Fed tightening, but not holding assets is not an option. This raises the question—how should investors think about holding beta in the current environment?
Investors now face drastically different circumstances compared to the last decade’s favorable environment for beta in general and equities in particular. From an alpha perspective, our outlook for assets is dim. We worry about the impact of the ongoing withdrawal of liquidity on assets (more so than on the economy itself), believe that markets are underpricing the amount of tightening that will be required to tame inflation, and see developed world policy makers as highly constrained.
At the same time, for most investors, not holding assets is not an option. Holding cash isn’t viable for most in a world in which it is destroying wealth at rate of 5% per year. Alpha can be extremely valuable, but it is difficult to generate and difficult to find at scale, as it requires unique insight not already priced into markets. That explains why roughly 90% of the risk in a typical institutional portfolio comes from the strategic asset allocation. Additionally, alpha views will often be wrong. Even the highest-conviction alpha views are at best 60/40 propositions. And those views can change quickly as market conditions unfold. So, we would hesitate to make big portfolio shifts on the basis of a handful of alpha views, including our own. Our approach to building a total portfolio has always been to build the best beta you can, independent of any active views, and then carefully layer in a diversified set of alphas to the degree that you have them or can find them in manager alpha.
That is to say, alpha is not to be ignored—just the opposite—but the most important question for most investors right now is: What is the best way to build a robust beta portfolio in an environment that seems likely to be difficult for assets for some time?
When we look at conditions today, the case for holding a balanced versus typical concentrated beta has never been stronger. The biggest vulnerabilities of typical portfolios are to falling discounted growth and rising discounted inflation, and we see the likelihood of that combination going forward—stagflation—to be the highest it has been in 100 years. Of course, these are active views and we could easily be wrong, just as we could easily be wrong about the risks we see to financial assets generally. But unlike the risks to all beta, there’s actually something that investors can do to deal with stagflation risk: take that risk off the table by getting more exposure to assets that could offer protection in that environment. A balanced portfolio is designed to take that risk off the table by going neutral to growth and inflation in the first place. And you don’t have to give up expected return to do this.
In the remainder of this report we expand on these thoughts. We review the recent performance of balanced beta in the context of the macro backdrop, discuss the prospects for beta going forward, and end with some thoughts on the challenges of investing in this environment.
When we look at what has happened in economies and markets so far this year, the outright and relative performance of typical beta portfolios and balanced beta makes sense. In brief: risk premiums and discount rates rose, hurting all assets. This is the risk inherent to beta, and there is no way of diversifying it away. At the same time, we have not yet seen the big shifts in discounted growth and inflation that are particularly bad for typical portfolios. As a result, all of the beta portfolios that we see are down by roughly similar amounts.
Below, we show the year-to-date returns of the major global asset classes. In terms of the headline numbers (shown left), all financial assets are down, and it looks like a particularly bad environment for equities. But this is illusory: once you adjust for risk (shown right), equities are middle-of-the-pack. Equities outperformed global nominal and inflation-linked bonds on a risk-adjusted basis.
Digging a level deeper, a perspective we often find helpful is to understand asset and portfolio returns in terms of their environmental biases and how the economic environment transpired. The colored boxes shown earlier depict the risk allocations of an illustrative institutional portfolio and a balanced portfolio to the four main economic scenarios that drive relative asset performance: rising and falling discounted growth and inflation. A typical portfolio has the bulk of its risk in pro-growth, falling-inflation assets, whereas a balanced portfolio spreads its risk equally across the four environments by holding assets that do well in each. Shifts in risk premiums (investors’ required compensation above cash for taking on risk) and discount rates (the expected return of cash itself) are the undiversifiable risks that all betas share. For a balanced portfolio, that’s essentially its only source of risk.
The charts below show how these macro forces have evolved over the course of the year, based on our gauges that look at relative asset performance and the returns of assets in aggregate versus cash. Discounted inflation rose, and risk premiums and discount rates both rose (as shown, their return impact on assets was negative). By our measures, discounted growth, while volatile over the period, actually rose on net since the beginning of the year.
The rise in discounted growth is perhaps counterintuitive in a period when equities fell significantly. But the hit to equities over the full period was mostly due to yields rising, not discounted earnings falling. As shown below, the longer-term path of discounted earnings for US equities hasn’t moved much, with strong growth still priced in (and what we’re showing as a slight decline in discounted earnings could also just be a rise in the equity risk premium). And when we take a broad look across assets, rising-growth assets overall significantly outperformed falling-growth assets. As shown earlier, corporate credit and equities have outperformed nominal and inflation-linked bonds on a risk-adjusted basis.
The important point is that however you cut it, major shifts in market pricing that are particularly bad for equities and typical portfolios haven’t yet occurred. With respect to inflation, while the move in discounted inflation can look big up close, it’s actually modest by historical standards. It’s nothing like what we saw in the 1970s and what we’d expect to see when markets price in a secular shift in inflation. This is consistent with markets continuing to price higher inflation to be largely transitory—breakeven inflation has risen but largely on the front end, with markets pricing inflation to normalize relatively quickly.
Given these macro forces, the outright and relative returns of a global 60/40 portfolio and a balanced one are understandable. All portfolios were hurt by rising risk premiums and discount rates. Typical portfolios like the global 60/40 were hurt by the rise in discounted inflation, but this was largely offset by the rise in discounted growth across assets. The charts above of the macro forces show that discounted inflation rose by more than discounted growth, but the sensitivity of a global 60/40 to discounted inflation is about half its sensitivity to discounted growth, so the two roughly netted out. As a result, a global 60/40 portfolio and balanced portfolio are down by a similar magnitude. The chart below puts the drawdowns of each portfolio in historical context: while significant, they are quite consistent with the range of returns we know to expect from each.
It’s worth mentioning that the above chart shows a balanced portfolio at a similar expected volatility to a global 60/40 portfolio, such that it has a significantly higher expected return. Since 1970, balance would have outperformed by several hundred basis points (gross). Run at a similar volatility to a global 60/40, it’s not surprising that the drawdowns are similar in magnitude—you’ve essentially chosen to take roughly the same amount of short-term risk to get a higher longer-term return. That outperformance over time comes in part from a quicker recovery on average (as shown, 20 versus 37 months to recover for the five largest drawdowns). But it’s a choice whether to use a more efficient portfolio to get a higher return for the same risk, or the same return for less risk (or somewhere in between). If you were to run a balanced portfolio at the same long-term return as a global 60/40, its drawdown year-to-date would have been significantly smaller (roughly half the size).
Based on the risk exposures of a typical portfolio, its biggest diversifiable vulnerability is to falling growth and rising inflation—i.e., stagflation. And since a balanced portfolio is designed to be neutral to those drivers, that’s also the environment where you’d expect the incremental benefit of balance to be the greatest. We haven’t seen stagflation yet, but (for what it’s worth) we think that’s likely where we’re headed.
When we say we haven’t seen stagflation yet, we mean in terms of market pricing— actual real growth has weakened and inflation has risen, but, as previously discussed, we haven’t seen any big decline in discounted growth. And inflation is still priced to normalize. Going forward, we assess the pressure for stagflation relative to market discounting to be the highest it’s been in about 100 years. We had a demand shock due to the impact of aggressive MP3 policies on balance sheets, and that kicked off a self-reinforcing wage-price spiral. And then on top of that, we had a supply shock due to the Russia-Ukraine conflict and more recently China’s lockdown, which are creating an additional need to spend to rebuild broken supply chains. Supply is struggling to keep up with demand, resulting in weak growth and high inflation that we expect to persist.
To be clear, these are alpha views and you should treat them as such. But if we’re right, we’re headed toward a particularly bad environment for typical portfolios on both an outright basis and relative to a balanced portfolio. And regardless of whether you agree with our view, from a strategic perspective the important question is whether the risk of such an environment is high enough that it makes sense to take that risk off the table.
For a balanced portfolio, the key question is what will happen with the “fifth box” of risk premiums and discount rates, and a key driver of this will be how aggressively central banks will tighten in the face of rising inflation and a weak economy (and how market pricing of this will change). This is a hard question, with market pricing having moved considerably since the beginning of the year and a significant amount of tightening now priced in (which of course drove the rise in discount rates so far this year). In our own alpha portfolios, we’re not expressing a strong view on how quickly central banks will need to tighten in the near term and are trying to be balanced to the different possible paths.
A tightening faster than markets are discounting would be a headwind to all assets, but how much faster matters a lot. As one perspective on this, the chart below shows the performance of a balanced portfolio versus a global 60/40 portfolio during past tightenings into rising inflation. These tend to be challenging periods for all assets, with a balanced portfolio having a flat return on average and a global 60/40 slightly negative on average. But there’s significant variation in returns across the cases as a function of the severity of the tightening. And importantly, in the year after the end of tightening—i.e., once the tightening bites and the economy starts to slow—balance significantly outperforms concentration on average, due to its exposure to assets that do well in falling growth.
Though even a balanced portfolio can and will experience significant losses at points in time, it’s worth putting in perspective that the nature of the risk that drives it is different from that of an unbalanced portfolio. Returns from risk premiums and discount rates tend to normalize over longer periods of time, as a) a spike in risk premiums implies higher expected returns going forward, and b) all assets underperforming cash by very much for very long will ultimately spill over into the economy and create a depression, and central banks will do everything in their power to prevent this.
Below, we show the rolling 10-year returns of a balanced portfolio versus a global 60/40 to illustrate this point. As shown, a typical portfolio would have had several decades of underperforming cash; the 10-year returns of a balanced portfolio dipped negative only once—and just barely—during the Volcker tightening.
As an illustrative case, a global 60/40 experienced a lost decade during the stagflationary 1970s—an environment that, while different in important ways from the current one, also shares elements of today’s macro backdrop.
A common question we get is how sensitive a balanced portfolio is to rising interest rates, as a balanced portfolio holds more nominal bonds than a typical one. It’s important to clarify that the reason why a balanced portfolio holds more bonds is to get balance to falling growth—just as it holds more real assets (commodities, inflation-linked bonds, etc.) in order to get balance to rising inflation. So, a balanced portfolio is no more a bond portfolio than it is an equity portfolio. And while over shorter periods rising rates can be driven by rising risk premiums and discount rates, over longer periods the drivers of interest rates tend to be the same ones that drive assets generally: shifts in growth and inflation. So, a portfolio that is balanced to growth and inflation is balanced to the primary drivers of interest rate moves over sustained periods.
Below, we show the performance of a balanced portfolio versus a global 60/40 during the secular rise in nominal rates starting in 1946 and then the secular fall in rates starting in 1981. As shown, a balanced portfolio outperformed the global 60/40 over the secular rise in rates as well as the secular fall in rates, and its returns were similarly strong over the two periods.
To us, the current environment calls for diversification in all forms. But a challenge is that the relationships between assets are changing, such that what will provide diversification is changing as well. Below, we show the correlations of equities to bonds and of equities to commodities. As shown, equities and bonds have become positively correlated, after being mostly negatively correlated over recent decades. And equities and commodities have become diversifying, after being highly correlated for many years.
What this means is that relying on trailing correlations to get diversification won’t work. But the correlations between assets have a logical basis: they are the result of the biases of assets and what macro driver is dominant. Below, we show the biases of equities, nominal bonds, and commodities by placing them in their respective quadrants.
As shown, equities and nominal bonds have opposite biases to growth—so when growth is the dominant driver (as it was over recent decades), they will be negatively correlated. But they have similar biases to inflation—so when inflation is the dominant driver (as it has been recently), they will be positively correlated. Equities and commodities have similar biases to growth but opposite biases to inflation, so they will be positively correlated when growth is dominant but negatively correlated when inflation is dominant.
In other words, without predicting what the dominant macro driver will be, you can’t know what the correlations between assets will be. A balanced portfolio avoids this problem by balancing to the fundamental drivers in the first place.
None of the preceding discussion is intended to suggest that there are easy answers to the question of how to invest in this environment. We believe strongly that beta investors should try to get as much balance and diversification as possible, but we say this knowing that a typical portfolio could easily outperform a balanced one over time frames that matter, and there are real risks to holding beta in any form.
We summarize the challenges that we see investors facing in the diagram below, broken down into the three components of portfolio return: the risk-neutral position (what an investor would hold in order not to take risk), beta, and alpha. The basic picture is that generating required returns has never been harder. We’ve discussed the risks to typical beta portfolios, as well as the risk to beta in any form. But holding cash isn’t a viable option for most, as its nominal return is low and real return is terrible. True diversifying alpha—alpha that can do well even when assets are doing poorly—is extremely valuable but also extremely difficult to find. And just as cross-asset correlations are changing, so too are the macro linkages more generally relative to what we’ve lived through over the past 40 years. So, approaches to alpha that are grounded in the relationships that have worked in the past are liable to struggle.
This makes the question of how best to hold beta a pressing one for most investors. Regardless of whether you agree with our approach to beta, we think this is the time to revisit strategic asset allocation, and specifically how to get portfolio diversification in a world in which inflation is the dominant driver and stagflation a quite plausible outcome.
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